Volatility: How you can use it to make profits in trading

What is Volatility?

Volatility is the amount of up-down movement of the price, of a financial instrument. Here is a list of financial instruments types that are affected by volatility: stock, bonds, currency, index, commodity, etc. Volatility does not measure the direction of price changes. It measures the dispersion of the price. In other words, volatility is a measure of the stability of a financial instrument.

How to Calculate Volatility:

How to calculate volatility?

Volatility is usually measured as the standard deviation of the annualized returns. High volatility means that the price of the financial instrument can change drastically in either direction. Low volatility means that change in the price is steady. Thus, high volatility means the financial instrument is unstable, and, low volatility means the financial instrument is stable.

For example, a financial instrument with a volatility of 60% is considered a high-risk investment instrument; as the financial instrument has the potential to increase or decrease up to 60% of its value. Thus, volatility is a key factor in assessing the risk of a financial instrument.

High/Low Volatility:

High/Low volatility depends on the perception of the trader based on what an acceptable risk ratio is for that specific person. Ultimately it differs from trader to trader, but this is what I consider high vs low volatility.

A recent market volatility from Feb-17 to Mar-17 is what I would classify as low volatility period.

However, the period from Apr-17 onward is what I classified as a period of high volatility.

Volatility Indicators:

Volatility is mainly indicated by:

1- Historical Volatility of Stocks:

Historical price data of the financial instrument is used to calculate the historical volatility.

It is not a forward-looking measure as it does not tell about the future volatility. Historical volatility is also known as statistical volatility, or, realized volatility.

2- Implied Volatility of Stocks:

Derived from the available market price of the traded options reflects the anticipated future volatility of the financial instrument. Option prices of options expiring in the future are used to calculate the implied volatility. The calculation considers the premium traders are willing to pay for the options expiring in the future. Thus, the implied volatility reflects the future volatility.

Implied volatility, denoted by (sigma), is often referred as “vol; or fear and greed index; or expected volatility.”

Volatility Index:

Introduced by Chicago Board Options Exchange (CBOE), the volatility index (VIX – Index) measures the short term implied volatility in the market. The CBOE VIX Index uses S&P 500 Index option series to calculate the implied volatility, or expected volatility.

Like the S&P 500 Index, the VIX Index, has VIX Futures and VIX Options. The VIX futures and options can be used for hedging, or, for trading. Remember, while trading VIX futures and options, a trader takes a call on the increase and decrease of the volatility; and not on the direction of the change.

Stocks and Volatility:

Beta of a stock is a measure of the relative volatility of a stock to the market. Beta of a stock provides an estimation of the overall return of the stock against the return of a relevant benchmark.

Example:

A stock with a beta value of 0.9 has historically moved 90% for every 100% move in the benchmark; based on price level.

Trading Options of Stock or Index:

The option prices, of puts as well as calls, increase with an increase in the volatility of the underlying asset. Volatility is the most important risk to consider before selling an option. It would be wise to sell an option when the volatility is high, and, to buy the options when the volatility is low.

Example:

Selling an option of a stock just before the release of earnings would be a bad move because the volatility generally increases right when the earnings are being announced, and for a little while after that. I would however, buy an option (if volatility is low) before the release of earnings, and, sell the options when the volatility has increased during, or, after the release of the earnings.

(www.marketwatch.com can be utilized to find about the earnings of almost all the companies traded on any of the major exchanges of US – date of earnings, financial results, etc.)

To profit from an increase in volatility, a trader should buy both, a Call and a Put; when the volatility is low. It would be advantageous to buy an “in the money Call”, and, an “in the money Put”. Suppose, Google is trading at $971 a day before the release of earnings. The trader should buy an in the money (ITM) Call – 967.5, and, an in the money (ITM) Put – 975, for the same expiry (ensure that the options expiration is after the announcement of the earnings).

The Profit/Loss of this position, at different prices of the underlying on expiry:

Pay Off Chart:

Other ways of using the Volatility:

1- A few days before the release of Fed minutes (can be found here), everything else being the same, volatility is considerably low. Hence, it would be wise to buy S&P options, and sell them after the announcement of the Fed minutes when volatility is higher.

2- Buy options of Crude Oil before the release of Crude Oil’s supply data – as volatility is low; and sell them after the release of the supply data, when the volatility is high.

Which option to buy in the two scenarios described above?

Buying both a put and a call to construct a straddle (future strategy to come) would be most profitable. There are two reasons for this:

a- With the increase in the volatility, the price of both the put, and, the call would increase; and,

b- There might be a big move resulting in a situation where one of the options (put or call) would trade at a price which would be more than what the trader paid to buy them both.

High Volatility Example:

If the volatility is getting increasingly higher, then selling “at the money” options would be profitable. “At the money” is a situation where an option’s strike price is identical to the price of the underlying security.

But wait, selling naked options is inviting trouble, and, possibly a step towards bankruptcy. You need to ensure that the sold options are always hedged (click here for more info on what a hedge is). The best way to achieve this would be to sell at the money (ATM) option, and, buy out of the money (OTM) option; as a hedge for the sold option – this will limit the loss.

Let’s say that the volatility is high, and the trader expects it to do down.

S&P is trading at 2415. In such a case, trader should

1- Buy S&P Call 2420

2- Sell S&P Call 2415

3- Sell S&P Put 2415

4- Buy S&P Put 2410

Ensure that all the options are of the same expiry.

In the example shown below, the S&P Options expire on May 30, 2017, and, the premium of the options is the last traded price of the, respective, option on Friday, May 26, 2017. In case of options, it is prudent to take money from the market on weekends; as time decay of option premiums for two non-trading days, Saturday and Sunday, will help the trader in this trade.

This strategy gives a net credit of the premium to the trader; as shown below.

Conclusion

When market volatility reaches a certain level, things can start to move so quickly that different tactics may be in order.

The key is to prepare in advance.

The tactics I discussed in this article should serve to give you some potential ideas to consider.

I hope you enjoyed this article on volatility and would love to hear your thoughts on it.

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